Municipal Bonds: This Year's Hottest Investment Strategy

The unsexy municipal bond is the year’s hottest investment strategy.

Usually around this time of year, according to Alfred, Lord Tennyson, a young man’s fancy lightly turns to thoughts of love. The great British poet was apparently unaware that by April 15 you have to file your taxes. Of course, this means that any illicit or obscene thoughts dancing in your head are probably directed at the Internal Revenue Service.

But there is one promising way, right now, to simultaneously boost your wealth and get your revenge on the IRS: Invest in municipal bonds. If you don’t know what those are, hang in there, I’m about to explain it to you. But know that the revenge part is real: You pay zero tax on the interest earned from muni bonds. (Fancy that? Thought so.) And the wealth part is real, too: The experts agree that muni bonds have become one of the surest investments in finance.

A bond is an investment in which you lend money in return for interest. (Sort of the opposite of a mortgage.) When you buy munis, you’re effectively lending money to cities, towns, or states, which use the money to build bridges or airports or football stadiums. They pay you back with interest, and Uncle Sam doesn’t tax those payouts. Why not? Because, since investors are getting a tax benefit, they usually accept lower interest payments, and that ultimately saves the municipality money.

But recently, tax-free muni bonds have been paying higher yields than the taxable bonds issued by the Federal Treasury. Historically, that’s a rare reversal, and it means you earn more but pay less in taxes. It may be as close as you’ll ever come to being Mitt Romney.

This unusual situation began with the financial crisis, when investors were running so scared they dumped everything except for Treasury bonds, which are seen as “risk free.” Munis recovered somewhat but then got hammered again in 2013 for two reasons. First, interest rates rose, which reduced the value of older, lower-yielding bonds. Second, the Detroit bankruptcy and a growing financial crisis in Puerto Rico spooked municipal bond investors. As a result, investors pulled about $60 billion from muni mutual funds last year. And the time to buy an asset is when everyone else is selling.

As other investors have fled, fee-only financial adviser Gary Schatsky has started recommending munis to clients, especially high earners—the higher your tax bracket, the bigger the benefit of tax-free income. He says munis have been “unfairly tarred” by the problems in Detroit, which means investors are buying low. “The added upside is obvious,” Schatsky says. “You save a substantial amount on taxes.” Other smart investors have been singing the praises of munis recently as well, including Burton Malkiel, whose book A Random Walk Down Wall Street is one of the most influential investing books of the past century.

Municipal finances, meanwhile, are actually getting healthier. Unlike the federal government, state governments are required to balance their budgets every year. In fact, 14 states have a triple-A rating, an honor the dysfunctional federal government lost in 2011.

Now, to be clear, you’re not going to shoot the lights out by investing in muni bonds. Munis will pay you 2.5–4.5%, and you might do a little better if the value of the bonds appreciates. But before you scoff, keep in mind: That’s a tax-free 4.5%. You keep it all. Virtually every other cent anyone pays you, whether it’s your boss, your bank, or an investment, gets cut by 20 or 30 or 40% on its way to your checking account. If this were a regular bond, it would have to pay an interest rate around 6.7% (depending on your tax bracket) in order for you to pocket the same amount of money. If you live in a city such as New York, with high state and local taxes, you’d have to earn more than 8% just to keep 4.5% after taxes. Good luck finding an investment as safe as a muni bond that will pay you 8%.

So, how to invest? The first question is whether to buy individual bonds or a mutual fund that holds lots of them. Most experts say you need close to $1 million to properly diversify a portfolio of individual bonds. So unless you’ve got a cool mil to invest, funds are the way to go.

Consider three types: A core fund that holds a broadly diversified mix of bonds from around the country; a closed-end fund, which can offer higher returns if you’re willing to take the extra risk; and a state-specific fund, which is worth a look for residents of high-tax areas. You may even want to spread your cash among all three. Keep in mind that you can lose money in these funds, especially if interest rates rise.

Steven Pikelny, a fund analyst at Morningstar, recommends Fidelity Intermediate Municipal Income (FLTMX) and BlackRock National Municipal (MDNLX), both of which weathered last year’s muni swoon better than competitors. The Fidelity fund was down 1.2% last year, the BlackRock fund lost 2.99%. They own exciting stuff like Clark County, NV, airport bonds that pay 5.75%. (Don’t knock it; next time you fly into Vegas you’ll look down at the tarmac with a special pride.) Schatsky also recommends the lower yielding Vanguard Limited-Term Tax-Exempt Fund Investor Shares (VMLTX), which managed to eke out a gain last year. Closed-end funds These are a special breed of fund that could offer more return, but the tradeoff is more risk. Closed-end shares trade throughout the day like stocks, and while their prices move up and down with their holdings, they’re also affected by the market’s sentiment toward whatever they hold. So if investors are bullish, they may pay more for the fund than its underlying assets are worth. When investors are bearish, they’ll pay less. At this writing, closed-end funds that own muni bonds were selling for 90–95 cents on the dollar. Pikelny warns that if interest rates continue to rise, investors in these funds can get hit hard, as they tend to own rate-sensitive bonds, and some borrow to juice returns—which can backfire if rates go up. Among his picks in the category is Nuveen Select Tax-Free Income (NXP), which doesn’t borrow and was selling for 6.6% less than the value of its holdings at press time.

These are a special breed of fund that could offer more return, but the tradeoff is more risk. Closed-end shares trade throughout the day like stocks, and while their prices move up and down with their holdings, they’re also affected by the market’s sentiment toward whatever they hold. So if investors are bullish, they may pay more for the fund than its underlying assets are worth. When investors are bearish, they’ll pay less.

At this writing, closed-end funds that own muni bonds were selling for 90–95 cents on the dollar. Pikelny warns that if interest rates continue to rise, investors in these funds can get hit hard, as they tend to own rate-sensitive bonds, and some borrow to juice returns—which can backfire if rates go up. Among his picks in the category is Nuveen Select Tax-Free Income (NXP), which doesn’t borrow and was selling for 6.6% less than the value of its holdings at press time.

Residents of high-tax cities in high-tax states face a special kind of hell at tax time. Not only does Uncle Sam take his share, but the local tax collectors also gnaw away at your hard-earned cash. If you fit into this category, consider a fund that specializes in bonds issued by agencies in your state. Fund company Vanguard, for example, offers low-cost funds for residents of California, Massachusetts, New York, Ohio, and other states. Keep in mind that these funds are, by their nature, less diversified, so that in the (highly unlikely) event of a default, you’d be at greater risk of losing money. The good news is that income from these bonds is “triple taxfree,” three words guaranteed to put a spring in your step.